Avoiding the “Dealer Problem”: When Does Your Fund Need Registration?

Nick Wright, BA JD MBA LLM (Tax)

Wright Business Law

Private investment fund sponsors in Canada must consider several distinct registration requirements when establishing a fund structure. Depending on the activities being conducted, dealer, investment fund manager (“IFM”) or adviser registration requirements may apply to the fund, general partner (“GP”), manager, sponsor or another entity involved in the structure.

The dealer question commonly arises because private funds issue securities to investors and their sponsors frequently participate in raising capital. The fact that a fund distributes its securities under a prospectus exemption does not determine whether a person involved in the distribution must be registered as a dealer.

For a fund sponsor, registration should be considered as part of the overall fund structure. The analysis should identify which entity performs each material function, including fund management, investment decision-making, capital raising and investor relations, and determine whether those activities engage separate registration requirements.

Registration at the Fund-Level

A private fund may involve several entities performing different functions.

For example, a limited partnership may have a GP responsible for the affairs of the partnership, a separate manager providing management and administrative services, a portfolio manager making investment decisions, and an exempt market dealer (“EMD”) distributing limited partnership units. In other structures, several functions may initially be performed by the sponsor or an affiliated entity.

The legal analysis should focus on what each entity actually does. The labels assigned in the organizational documents do not determine whether registration is required.

Three registration categories are particularly relevant:

• Dealer registration concerns engaging in the business of trading in securities.
• Adviser registration concerns engaging in the business of advising others with respect to investing in, buying or selling securities.
• IFM registration concerns directing the business, operations or affairs of an investment fund.

A fund sponsor may therefore need to consider more than one registration category when establishing its structure.

The Dealer Registration Requirement

Subsection 25(1) of the Securities Act (Ontario) generally requires registration where a person or company engages in, or holds itself out as engaging in, the business of trading in securities, unless an exemption is available.

A private fund engages in trading activity when it issues units, shares or other securities to investors. That does not necessarily mean that the fund, GP or manager must be registered as a dealer. The further question is whether the relevant person is conducting trading activity as a business.

The Companion Policy to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31-103”) identifies a non-exhaustive group of factors relevant to that determination, including:

• activities similar to those of a registrant;
• intermediation of trades;
• repetition, regularity or continuity;
• remuneration or expected remuneration associated with the activity; and
• direct or indirect solicitation of securities transactions.

No single factor necessarily determines the result. The activities must be considered collectively and in context.

For a private fund, this means considering who identifies and solicits prospective investors, who presents the investment opportunity, who communicates with investors concerning subscriptions, whether compensation is connected to capital raised, whether dedicated fundraising personnel are used and whether securities distribution has become a distinct organizational function.

Investment Funds and Operating Businesses

The nature of the underlying structure can also be relevant.

An operating company ordinarily raises capital to finance an identifiable operating business. A project-specific real estate limited partnership may similarly raise capital for the acquisition, development or operation of a particular property.

A conventional pooled investment fund may present different facts because the investment and management of contributed capital may itself constitute the fund’s underlying business.

This distinction does not create a categorical registration rule. The characterization of the structure and the relationship between its securities distributions and underlying activities form part of the overall business-trigger analysis.

This issue can be particularly important for real estate, private equity and other structures described commercially as “funds” that may, depending on their activities, more closely resemble operating or development businesses.

Identifying Who Raises the Capital

An important structural question is identifying which entity and individuals actually conduct the distribution.

The fund may issue the securities while personnel of the manager identify prospective investors, conduct presentations and coordinate subscriptions. The GP may conduct investor communications. An affiliated entity may employ investor-relations personnel. Alternatively, a third-party EMD may perform substantially all distribution activities.

The fund documents should correspond to this operational reality.

If a management agreement assigns capital raising and investor solicitation to the manager, those functions should be considered when assessing the manager’s registration position. Describing the GP as responsible for distributions carries limited significance if another entity actually performs the fundraising.

Fund formation therefore provides an appropriate time to map the distribution function and determine which entity will perform it.

Fundraising Personnel and Third-Party Intermediaries

The activities of employees, officers, principals, finders and capital-raising consultants should also be considered.

Senior management will often meet prospective investors, explain the investment strategy and participate in fundraising. Those activities do not automatically establish that the individuals or their employer are in the business of trading securities.

The analysis becomes more significant where personnel are principally responsible for obtaining investors, engage systematically in solicitation, maintain an investor pipeline or receive compensation linked to successful subscriptions.

Third-party intermediaries require separate analysis. A conclusion that the fund, GP or manager is not itself in the business of trading does not establish that an unrelated finder or consultant may solicit investors without registration.

Particular attention should be given where an intermediary solicits investors, participates in substantive investment discussions, recommends the securities, assists with subscriptions or receives transaction-based compensation.

The title given to the intermediary does not determine the registration analysis. Its actual activities are what matter.

Using an Exempt Market Dealer

A fund sponsor may determine that some or all distribution activities should be conducted through a registered EMD.

Paragraph 7.1(2)(d) of NI 31-103 establishes the EMD registration category. Depending on the engagement, an EMD may conduct investor solicitation and perform KYC, KYP, suitability, conflicts management, onboarding and other dealer functions associated with the distribution.

Engaging an EMD does not transfer every securities-law obligation associated with the offering to the dealer. The fund and sponsor remain responsible for obligations imposed directly on them.

The allocation of functions should therefore be reflected consistently in the EMD agreement, offering memorandum, subscription documents and actual distribution procedures.

Dealer Registration and IFM Registration

Dealer registration is only one component of the registration analysis for a private fund.

NI 31-103 separately establishes the IFM registration category. An entity that directs the business, operations or affairs of an investment fund may be required to register as an IFM, subject to applicable requirements and exemptions.

The threshold question is whether the vehicle is an “investment fund” for securities-law purposes.

This can require particular analysis for private real estate, private equity and other alternative investment structures. A vehicle actively engaged in developing, managing or operating an underlying business may present different issues from a conventional pooled fund investing contributed capital on behalf of investors.

Where the vehicle is an investment fund, the sponsor should identify which entity directs its business, operations or affairs and assess the resulting IFM registration requirements.

Dealer and IFM registration concern different functions. The conclusion reached for one category does not determine the analysis under the other.

Adviser Registration and Investment Management

Investment decision-making presents a third registration question.

A person or company that is in the business of advising others with respect to investing in, buying or selling securities may engage adviser registration requirements.

The fund structure should therefore identify who makes investment decisions and in what capacity. Depending on the structure, investment decisions may be made by a registered portfolio manager, an affiliated entity, the GP or another investment decision-maker.

The applicable analysis depends on the nature of the assets and the activities performed. Acting as the fund’s manager does not itself resolve whether adviser registration requirements are also engaged.

Aligning the Fund Documents with the Registration Structure

The intended registration structure should be reflected consistently throughout the fund documents.

The limited partnership agreement, declaration of trust or other governing instrument should identify the powers of the GP, trustee and manager consistently with the intended structure. The management agreement should accurately describe the manager’s functions, particularly where they include investor relations or capital raising.

The offering memorandum should describe the respective roles of the manager, GP, portfolio manager and dealer consistently with the underlying agreements. The EMD agreement should correspond to the actual distribution process.

Inconsistencies among these documents can create uncertainty about which entity actually performs a potentially registrable function.

Registration analysis should therefore form part of the fund-formation and document-drafting process rather than being considered only after the offering documents have been prepared.

Reassessing the Structure

Registration analysis should also be revisited when a fund’s activities materially change.

A sponsor may initially raise capital through its founders and senior management but later establish an investor-relations team, retain finders, introduce transaction-based compensation, expand into additional jurisdictions or establish successor funds.

Changes to the fund’s investment activities or management structure may similarly affect IFM or adviser-registration considerations.

The regulatory structure should therefore develop with the fund’s actual activities.

A Fund-Formation Registration Framework

Before finalizing a private fund structure, the sponsor should identify:

1. Issuer: Which entity issues the securities?
2. Manager: Which entity directs the fund’s business, operations or affairs, and is the vehicle an investment fund?
3. Investment decision-maker: Who selects and manages the investments, and does that activity engage adviser registration
4. Distributor: Who identifies, solicits and communicates with prospective investors?
5. Fundraising personnel: What fundraising activities will employees, officers and principals perform?
6. Intermediaries: Will finders, referral sources or consultants participate in the distribution, and what is their registration status?
7. Registered dealer: Will an EMD or another registered dealer perform some or all of the distribution function?
8. Documentation: Do the governing documents, management agreement, offering memorandum, subscription agreement and dealer agreement describe these functions consistently?

This approach treats registration as a structural fund-formation issue rather than a question arising only when the first subscription is accepted.

Conclusion

For private funds, the “dealer problem” is one component of a broader registration analysis.

A fund sponsor should identify which entities and individuals perform fund management, investment management and securities-distribution functions and determine whether those activities engage IFM, adviser or dealer registration requirements.

Where the fund or sponsor participates directly in capital raising, the dealer analysis turns on whether the relevant person is engaging in the business of trading securities.

For a fund being established, the practical objective is to determine the intended regulatory structure before the organizational and offering documents are finalized. The GP, manager, investment decision-maker and distributor should have clearly defined functions, and the fund documents should accurately reflect how those functions will be performed.

Book a Consultation

If you are forming or restructuring a private investment fund and require advice concerning dealer, investment fund manager or portfolio manager registration requirements, contact us to schedule an initial consultation with Nick Wright.